Sheila Bair is a straight shooter. And as such, she laid it on the line today in her prepared remarks before Congress. Her remarks were on the money on several counts. I will highlight just a few with commentary followed by the relevant quotes. A link to the testimony is provided at the end. Notice the scathing remarks about the Fed.
- Sheila Bair said that regulations enacted at the end of the S&L crisis were circumvented as more and more activities began to performed outside of the regulatory umbrella in the Shadow Banking System.
The last major financial crisis—the thrift and banking crisis of the 1980s—resulted in enactment of two laws designed to improve the financial regulatory system: The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) and the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). Combined, FIRREA and FDICIA significantly strengthened bank regulation, and provided banks strong incentives to operate at higher capital levels with less risk, but these regulations have also created incentives for financial services to grow outside of the regulated sector.
In the 20 years following FIRREA and FDICIA, the shadow banking system grew much more quickly than the traditional banking system, and at the onset of the crisis, it’s been estimated that half of all financial services were conducted in institutions that were not subject to prudential regulation and supervision. Products and practices that originated within the shadow banking system have proven particularly troublesome in this crisis. In particular, the crisis has shown that many of the institutions in this sector grew to be too large and complex to resolve under existing bankruptcy law and currently they cannot be wound down under the FDIC’s receivership authorities.
- She also suggested that we are not making reforms which get at root causes of the current crisis.
We are now poised to undertake far-reaching changes that will affect the regulation of our entire financial system, including the shadow banking sector. Our reforms must address the causes of the crisis, if we are to reduce as far as possible the chance that it will recur. The financial crisis calls into question the fundamental assumptions regarding financial supervision, credit availability, and market discipline that have informed our regulatory efforts for decades. We must reassess whether financial institutions can be properly managed and effectively supervised through existing mechanisms and techniques.
Our approach must be holistic, giving regulators the tools to address risk throughout the system, not just in those insured banks where we have long recognized that heightened prudential supervision is necessary.
- Mortgage-Backed Securities created a disconnect between loan originators and owners of mortgages that led to reckless lending. [One reason Fannie and Freddie should not exist].
The growth of GSEs and the originate-to-distribute model of mortgage finance
Many of the products and practices that led to the financial crisis have their roots in the mortgage market innovations that began in the 1980s and matured in the 1990s. Following large interest-rate losses from residential mortgage investments that precipitated the thrift crisis in the 1980s, banks and thrifts began selling or securitizing a major share of their mortgage loans with the housing government sponsored enterprises (GSEs). By focusing on originating, rather than holding, mortgages, banks and thrifts were able to reduce their interest-rate and credit risk, increase liquidity, and lower their regulatory capital requirements under the rules that went into effect in the early 1990s.
- The Federal Reserve was a weak regulator and allowed reckless lending to occur for seven years after it was given regulatory control. Bair says:
If HOEPA regulations had been amended in 2001, instead of in 2008, a large number of the toxic mortgage loans could not have been originated and much of the crisis may have been prevented. The FDIC strongly supported the FRB’s promulgation of an "ability to repay" standard for high priced loans in 2008, and continues to urge the FRB to apply common sense, "ability to repay" requirements to all mortgages, including interest-only and option-ARM loans.
- Bair implied that the Federal Reserve and the SEC were blind to the need to prepare in advance for systemic issues. Had they made adequate preparations, we could have dealt with Lehman or bear Stearns and other weak institutions via bankruptcy, asset seizure and re-privatization/liquidation. This is a primary reason – in conjunction with their failure to regulate – that they should not receive more regulatory responsibilities. The Federal Reserve should focus on monetary policy and be stripped of regulatory duties.
Regulators were wholly unprepared and ill-equipped for a systemic event that initially destroyed liquidity in the shadow banking system and subsequently spread to the largest firms throughout the financial system.
Hard-hitting, fact-based and prescriptive. What’s not to like about these statements from Bair? The fact that she has no designs on going into the financial services sector after government says a lot.
There’s a lot more at the link below.
Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation on the Causes and Current State of the Financial Crisis before the Financial Crisis Inquiry Commission; Room 1100, Longworth House Office Building, January 14, 2010